As the People's Republic of China evolves toward a market economy, capital markets are likely to replace the government as the firm's primary source of funds for investment. Nevertheless, the Chinese government remains the prin- cipal owner of many Chinese firms. Some of these firms use the government's borrowing cost (such as the rate on certificates of deposit from the Industrial Bank of China) as their required return or hurdle rate on new investment.

a. Is it appropriate to use the government's borrowing cost as a required return on investment if a firm is 100 percent owned by the government?

b. Are investments based on this criterion likely to be value-creating or value- destroying from a capital markets perspective? What consequence will the use of this hurdle rate have for the risk of the firm's and the government's asset portfolios? Explain.

c. A Chinese manager is considering an investment of 1.5 million Chinese new yuan (CNY) in a coal mine that generates an expected return of 100,000CNY per year in perpetuity. The government's borrowing rate is 5 percent. The project has a beta of 1.0 and a risk-adjusted required return of 10 percent. What is the NPV of this investment using the government's borrowing cost of 5 percent? What is the NPV of this investment using a risk-adjusted return of 10 percent?

d. The Chinese manager expects her division to be privatized in one year. Fur- ther, suppose the government does not monitor returns on its investments once they have been made. What will be the likely consequence of accepting the project in part c on the market value of her division after privatization? Does the manager have an incentive to extract as much capital from the government as possible prior to privatization, even at the cost of accept- ing negative-NPV projects? (Hint: Think of the agency conflict between managers and other stakeholders.)